Central Banks’ Unorthodox Actions Are Cutting Lending

July 31 (Bloomberg) -- The unintended consequences of
financial policy intervention are providing fresh evidence for
chaos theory’s idea that the flap of a butterfly’s wings can
spark a tornado on the other side of the world.

Five years into the age of deleveraging, financial markets
have become addicted to central bank intervention, from the U.S.
Federal Reserve to the European Central Bank and beyond, aimed
at stimulating growth. Markets anticipate further action, with
the Fed, ECB and Bank of England committees meeting on monetary
policy this week.

But no flap of a central banker’s wings goes quite as
expected.

Take China’s heroic 2008-2009 stimulus program, which
helped fight back a global recession. It also led to huge
overinvestment and bad debt, and the policy is now viewed by
many economists as an error.

Similarly, the ECB’s long-term multibillion-euro
refinancing operation, announced in December 2011, saved
Europe’s banking system from a funding crisis. But it created a
dangerous web of links between an overleveraged banking sector
and already indebted sovereigns.

Official lending rates are close to zero, and their
manipulation, the traditional mainstay of monetary policy, is
effectively impotent. The new go-to tool for central bankers,
quantitative easing, is suffering from declining marginal
returns.

Unorthodox Action

As the International Monetary Fund economist Manmohan Singh
notes in a working paper published this month, the Fed’s
quantitative easing policy replaced long-term Treasuries with
short-term bills or cash, which circulate less quickly through
the system as collateral for bank funding.

The bottom line is that the very actions central banks and
regulators have been taking to increase confidence in the
banking sector might be undermining banks’ ability to lend.
Although central bank actions have lowered longer term borrowing
costs, this has not spurred credit demand. Businesses and
households are either so frightened or so overleveraged that
they’re saving and cutting debt, no matter how cheap it is to
borrow.

In part because lending remains weak, and in part because
some of their own efforts are starting to work against them,
central banks are forced to become increasingly unorthodox in
their efforts to stimulate growth. In one measure announced last
week, the Bank of England, together with the U.K. Treasury,
started a “funding for lending” initiative, in effect channeling
central bank money directly to consumers and businesses -- an
unprecedented move.

The ECB has made some of the most striking innovations, yet
these do not seem to be boosting bank lending either. At its
meeting in July, for example, the ECB cut its deposit rate to
zero in an effort to get more than 800 billion euros ($980
billion) -- equivalent to 8 percent of the euro area’s gross
domestic product -- that commercial banks had parked in the
ECB’s accounts out into the wider economy.

The amount held on deposit at the ECB declined by more than
half, but the money didn’t flow into new lending. Instead, some
depositors started using the central bank’s reserve facility,
which also pays zero rates but offers better liquidity. Other
investors drove Austrian, Dutch, Finnish and German two-year
bond yields negative as they rushed to place their cash. They
also took on more risk, either by buying longer-term paper
(five-year German bund yields fell by 0.12 percentage points in
the two weeks after the cut) or by investing in riskier short-term paper (AA-rated French two-year bond yields fell by 0.28
percentage points). Even yields on Bulgarian six-month euro-denominated bonds halved in the two weeks after the ECB action.

Lower Yields

These ripples in the market have reduced yields available
on the high-quality bonds that banks are required to hold, and
cut the spread between short- and long-term interest rates to a
three-year low. Both outcomes make it less profitable for banks
to lend.

Of course, the fall in profits from bank lending is not the
sole fault of the ECB. New regulatory capital requirements,
designed to make banks safer and boost confidence in the system,
require banks to deleverage and cut lending. McKinsey & Co.
estimates that the return on equity for retail banks has dropped
to 6 percent (from 10 percent) as a result of new regulatory
requirements.

The question today is not whether the ECB’s latest action
in cutting deposit rates will boost lending, but whether it will
unintentionally crimp lending further. A number of euro-denominated money-market funds were forced to close to new
entrants after the ECB’s deposit rate cut, because returns after
fees became negative. Further closings could cut off an
important source of funding for the banking sector.

Now some ECB members are discussing the possibility of
introducing negative deposit rates. This would send investors on
a renewed hunt for yield, and leave banks with the options of
lending, hoarding physical cash in vaults or paying for the
privilege of holding cash at the ECB. That’s a stark choice, but
it still might not boost loan growth. A survey of the ECB’s
money-market experts suggested that 75 percent of banks would
not change their behavior, even with a negative rate. If this
proves to be the case, central banks may need to get more daring
still. And each new action will risk new unintended
consequences.

Central bankers have taken bold actions in recent years to
stave off systemic collapse and to try to fight slow growth. But
chaos theory teaches us that dynamic systems are sensitive and
unpredictable. From now on, central bankers need to pay more
heed to what the real impact of their policy measures will be.

Improving Confidence

There are ways of boosting growth and lending without
having to experiment with untested policies. Investors’ aversion
to risk, banks’ aversion to lending and business’ aversion to
borrowing are as much about a lack of confidence in the future
as anything else. Firmer statements of support from central
bankers, politicians and regulators could go a long way toward
solving this crisis of confidence.

ECB President Mario Draghi’s promise last week to do
“whatever it takes” to preserve the euro was a case in point,
and led to a sharp rally in risk assets. Similar pledges to act
as the euro area’s lender of the last resort and tolerate higher
inflation would be just as beneficial -- and without having to
leap further into the unknown.

(Alexander Friedman is global chief investment officer at
UBS AG and Kiran Ganesh is a cross-asset strategist for UBS
Wealth Management, overseeing $1.6 trillion. The opinions
expressed are their own.)

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